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By Linda L. Griggs, John J. Huber, and Christian J. Mixter
Ms. Griggs is a Consultant, and Mr. Mixter is a partner, with Morgan, Lewis & Bockius LLP in Washington, D.C. Mr. Huber is an Affiliate with FTI Consulting in Washington, D.C. The views expressed herein are those of the authors and do not necessarily represent the views of FTI Consulting, Inc., Morgan Lewis or their other professionals.
The Supreme Court is poised to decide whether sub-item (a)(3)(ii) of Item 303 of Regulation S-K, Management’s Discussion and Analysis of Financial Condition and Results of Operations, 17 C.F.R. §229.303 (“MD&A” or “Item 303”),creates a duty to disclose that is actionable by private plaintiffs under Rule 10b-5, 17 CFR §240.10b-5, adopted pursuant to Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”), 15 USC §78j(b). If the Court concludes that Item 303 creates such a duty, the Court will likely also address other conditions to Rule 10b-5 liability, such as materiality and scienter. The vehicle for that decision will be the Supreme Court’s review of Indiana Public Retirement System v. SAIC, Inc., 818 F.3d 85 (2d Cir. 2016). (Because of a corporate name change, we refer to both the defendant company and the Second Circuit’s decision as “ Leidos.”) In Leidos, the Second Circuit broke with the Third and Ninth Circuits and held that a public company that omits a disclosure required by Item 303 violates a duty to disclose under Rule 10b-5. In resolving this conflict between the circuits with respect to Item 303(a)(3)(ii), the Court’s decision will also likely affect whether Rule 10b-5 would apply to a violation of every other sub-item of Item 303 as well as every one of the disclosure requirements adopted by the Securities and Exchange Commission (the “SEC” or the “Commission”) under Sections 13(a) and 15(d) and perhaps Section 14(a) of the Exchange Act, which would usher in a new era of litigation under Rule 10b-5.
This Article considers the issues before the Supreme Court from three perspectives. In Part I, we discussed the history and purpose of Item 303, as well as the SEC’s enforcement of the disclosure requirements contained in that Item. In Parts II and III, we summarize the circuit split, make some observations about the legal implications of the Second Circuit’s decision, and discuss the likely negative effects that would flow from a Supreme Court affirmance of that decision.
In granting Leidos’ petition for certiorari, the Supreme Court agreed to resolve a circuit split between the Second Circuit’s decision in Leidos and the Ninth Circuit’s decision in In re NVIDIA Corp. Securities Litigation, 768 F.3d 1046 (9th Cir. 2014). The Second Circuit and the Ninth Circuit each claim that its view on the existence of an Item 303 duty is consistent with the Third Circuit’s decision in Oran v. Stafford, 226 F.3d 275 (3d Cir. 2000), which merits discussion here both because of that disparate treatment and because it was authored by then-Circuit Judge Alito, who now sits on the Supreme Court.
As the earliest of the three opinions to consider Item 303 and Rule 10b-5, Oran wrote on the cleanest slate, although even then that slate was not quite pristine. As the Oran opinion notes, the Third Circuit itself had previously mentioned, but left open, the issue whether Item 303 violations create an independent cause of action for plaintiffs, seeIn re Burlington Coat Factory Sec. Litig., 114 F.3d 1410, 1419 n.7 (3d Cir. 1997), and the Sixth Circuit had found unpersuasive the argument that a duty to disclose under Rule 10b-5 could stem from Item 303. SeeIn re Sofamor Danek Group, Inc., 123 F.3d 394, 403 (6th Cir. 1997). In addition, the Ninth Circuit had issued a trilogy of decisions suggesting strongly that Item 303 could not be used to show a violation of Section 10(b) and Rule 10b-5. See In re VeriFone Sec. Litig., 11 F.3d 865, 870 (9th Cir. 1993); In re Lyondell Petrochemical Co. Sec. Litig., 984 F.2d 1050, 1053 (9th Cir. 1993); In re Convergent Techs. Sec. Litig., 948 F.2d 507, 516 (9th Cir. 1991).
The plaintiffs in Oran alleged that the defendant public company failed to make timely disclosure of the side effects of a weight-loss drug that the company produced. After weighing and rejecting plaintiffs’ arguments that the information the company knew but failed to disclose was material, the court took up plaintiffs’ contention that Item 303(a) obliged the defendant company to disclose what it knew about the side effects as a “known trend or uncertainty.” The Third Circuit first ruled that a violation of Item 303 does not create an independent cause of action for private plaintiffs. See 226 F.3d at 287. The court then considered whether Item 303 supplies a duty of disclosure that, if violated, would support liability under Section 10(b) and Rule 10b-5. The Third Circuit noted that the SEC’s Two Step Test, discussed above, “varies considerably from the general test for securities fraud materiality set out by the Supreme Court in Basic Inc. v. Levinson.” See id. at 288. Accordingly, the court held that
Because the materiality standards for Rule 10b-5 and SK-303 differ significantly, the “demonstration of a violation of the disclosure requirements of Item 303 does not lead inevitably to the conclusion that such disclosure would be required under Rule 10b-5. Such a duty to disclose must be separately shown.” … We find this reasoning persuasive, and thus hold that a violation of SK-303’s reporting requirements does not automatically give rise to a material omission under Rule 10b-5. Because plaintiffs have failed to plead any actionable misrepresentation or omission under that Rule, SK-303 cannot provide a basis for liability.Id., quoting Alfus v. Pyramid Tech, Corp., 764 F. Supp. 598, 608 (N.D. Cal. 1991) [other citations and footnote omitted]. As we will see, this short paragraph would be viewed very differently by the Ninth and Second Circuits, with the Ninth Circuit focusing on the conclusion in the second sentence that a Rule 10b-5 duty to disclose must be shown separately from Item 303, and the Second Circuit perceiving, in the Third Circuit’s use of the word “automatically” in the next sentence, an implied hole big enough to admit Item 303-based liability.
During the fourteen-year interlude between Oran and NVIDIA, a number of courts of appeals affirmed that Item 303 could trigger liability under Sections 11 and 12(a)(2) of the Securities Act of 1933. See Silverstrand Invs. v. AMAG Pharmaceuticals, Inc., 707 F.3d 95, 102-03 (1st Cir. 2013); Panther Partners Inc. v. Ikanos Communications, Inc. (2d Cir. 2012); Litwin v. The Blackstone Group, 634 F.3d 706 (2d Cir. 2011); J&R Marketing, SEP v. General Motors Corp., 549 F.3d 384, 390-91 (6th Cir. 2008); see also Steckman v. Hart Brewing, Inc., 143 F.3d 1293, 1296 (9th Cir. 1998). In Oran v. Stafford, the Third Circuit noted that in Steckman, “the court carefully limited its [Section 11/Section 12(a)(2)] holding …, making clear that it did not extend to claims under Section 10(b) or Rule 10b-5.” Oran, 226 F.3d at 288 n.12.
Although the Supreme Court has never considered, and is not bound by, lower courts’ rulings that an omission of Item 303 disclosure can be the basis for liability under Sections 11 and 12(a)(2) of the Securities Act, such liability is consistent with the structure and purpose of the Securities Act. Sections 11 and 12(a)(2) provide strictly-circumscribed remedies to plaintiffs who make claims under particular types of documents – respectively, registration statements and prospectuses. Standing is restricted to persons who purchased shares covered by a defective registration statement or who can trace their purchases directly to those shares (Section 11) or to persons who made a direct purchase of a security from a statutory seller as part of a public offering (Section 12). Within the Securities Act, Section 7 addresses the information required to be presented in registration statements, and Section 10 deals with prospectuses. Both sections refer to Appendix A of the Securities Act and to the SEC’s rulemaking power to require other disclosures to be presented. Pursuant to that rulemaking power, registration statements and prospectuses must contain the information required by Regulation S-K. Sections 11 and 12(a)(2) predicate liability upon shortcomings in those particular documents, as follows:
Just as they did with the Third Circuit’s language in Oran, the Ninth Circuit and the Second Circuit drew radically different conclusions from the courts’ acceptance of Section 11/Section 12 liability based on Item 303.
The NVIDIA Corporation Securities Litigation involved claimed nondisclosure of defects in semiconductor products. Plaintiffs argued that NVIDIA should have disclosed what it knew about the defects as a “known trend or uncertainty” under Item 303. Concluding that its own prior decisions suggested, but did not squarely hold, that an Item 303 violation cannot support a violation of Section 10(b) and Rule 10b-5, the Ninth Circuit turned to the Third Circuit’s materiality-based analysis in Oran, which it found both persuasive and conclusive. 768 F.3d at 1054-55. The court also firmly rejected plaintiffs’ argument that precedent under Sections 11 and 12 of the Securities Act supported finding an Item 303 duty under Section 10(b) and Rule 10b-5, noting that, unlike Sections 11 and 12, Section 10(b) and Rule 10b-5 impose no affirmative disclosure requirements, and that, under Supreme Court precedent, “for purposes of Section 10(b) and Rule 10b-5, material information need not be disclosed unless omission of that information would cause other information that is disclosed to be misleading,” id. at 1056, citing Matrixx Initiatives v. Siracusano, 563 U.S. 27, 44 (2011).
From the Second Circuit’s point of view, its holding in Leidos that Item 303 can supply a duty to disclose for purposes of Section 10(b) and Rule 10b-5 was anticlimactic because it had made the identical ruling more than a year earlier in Stratte-McClure v. Morgan Stanley, 776 F.3d 94 (2d Cir. 2015). Despite the reasons, discussed above, to treat Section 12(a)(2) differently from Section 10(b) and Rule 10b-5, the Second Circuit began and ended its discussion of Item 303 and Rule 10b-5 in Stratte-McClure with citations to its recent Securities Act decisions and the observation that Section 12(a)(2) and Rule 10b-5 both require disclosure of ‘material fact[s] necessary in order to make … statements made … not misleading.’” 776 F.3d at 102, 104. The court also cited four appellate decisions for the proposition that “a duty to disclose under Section 10(b) can derive from statutes or regulations that obligate a party to speak,” even though each of those opinions was, at best, speaking in dictum about a possible breach of duty. Id., citing Glazer v. Formica Corp., 964 F.2d 149 (2d Cir. 1992) (the reference is apparently to page 157, where Glazer cites Backman, below, for the general proposition that there may be a “statute or regulation requiring disclosure”); Backman v. Polaroid Corp., 910 F.2d 10, 20 (1st Cir. 1990) (the court’s citation is to the dissenting opinion in the case, which only referred to the possibility that “a statute or regulation [might] require disclosure”); Oran v. Stafford (where, as noted above, the court found no duty to disclose); and Gallagher v. Abbott Labs., 269 F.3d 806, 808 (7th Cir. 2001) (in which the court did consider the possibility that “known trends or uncertainties” could give rise to a duty to speak, but decided that the trend at issue was not known to the registrant at the time its Form 10-K was issued).
The Stratte-McClure court could not specifically relate Item 303 to any specific requirement of the statutory provision – Section 10(b) – that it was construing. (If the SEC wished to add a requirement for disclosure of “known trends and uncertainties” under Section 10(b), it presumably could do so by issuing an appropriate rule under Section 10(b) itself, as it did by prohibiting certain representations in securities offerings (see Rule 10b-9) and requiring disclosure of credit terms in margin transactions (Rule 10b-16). The agency has made no move in that direction, relying instead on provisions other than Section 10(b) as the authority for its MD&A requirements (see Part I above).)
The Second Circuit also tried to classify an Item 303 omission as a “half-truth” by making the questionable observation – supported by a single sentence in a law review article – that a reasonable investor reading a Form 10-K or Form 10-Q would know that such a filing is supposed to contain Item 303 disclosure and, if a particular trend or uncertainty did not appear, would reasonably infer its nonexistence. 776 F.3d at 102, citing Donald C. Langevoort and G. Mitu Gulati, The Muddled Duty to Disclose Under Rule 10b-5, 57 Vand. L.Rev. 1639, 1680 (2004). The Second Circuit also cited as support for its holding a settled SEC enforcement case that described an Item 303 failure as a violation of Section 10(b) and Rule 10b-5. See 776 F.3d at 102 n. 5, citing In the Matter of Valley Systems, Inc., Exchange Act Rel. No. 36227 (Sept. 14, 1995); see discussion of SEC enforcement cases in Part I above.
The conclusions that Item 303 supplies a Rule 10b-5 duty to disclose and that the defendant had breached that duty did not end the Second Circuit’s work in Stratte-McClure. Having come that far, the Second Circuit addressed the other elements of a Rule 10b-5 claim. First up was materiality. Here, the Second Circuit returned to Oran v. Stafford; noting the Third Circuit’s observation that Item 303 requires a lesser standard of materiality than that mandated by Basic Inc. v. Levinson, the court held that a plaintiff who wished to predicate a Rule 10b-5 claim on Item 303 must meet the more rigorous Basic test to prevail on its claim. The Second Circuit used this requirement – which it assumed Stratte-McClure could meet – to attempt to square its Item 303 ruling with Oran. 776 F.3d at 103. Specifically, the Second Circuit interpreted the Third Circuit’s use of the word “automatically” in Oran (“a violation of SK-303’s reporting requirements does not automatically give rise to a material omission under Rule 10b-5,” 226 F.3d at 288) to mean that the Third Circuit would be comfortable with an Item 303-based duty so long as the Basic materiality requirement was overlaid on it.
Finally, the Second Circuit addressed scienter. Here, plaintiff’s claims foundered because the Second Circuit concluded that the complaint did not give rise to a strong inference of scienter. 776 F.3d at 106-109. Defendant having prevailed on scienter (and thus in the litigation), there was no one to petition for certiorari on the “Item 303 duty” aspect of Stratte-McClure, and the case ended.
In Leidos, unlike in Stratte-McClure, the defendant was not the prevailing party. The plaintiffs claimed that Leidos had waited too long to disclose what it knew about its exposure to liability for its employees’ fraud in connection with Leidos’ contracts with New York City. Plaintiffs pleaded those claims under two different theories: non-compliance with GAAP by failing to disclose appropriate loss contingencies associated with the contract, in violation of Financial Accounting Standard No. 5 (“FAS 5,” now Financial Accounting Standards Board Accounting Standards Codification Topic 450-20), and failure to disclose the underlying facts as a known trend or uncertainty under Item 303(a)(3)(ii). The Second Circuit agreed with plaintiffs on both theories. (Leidos did not seek certiorari with respect to the FAS 5 theory, so no matter what the Supreme Court may decide about Item 303, the Leidos litigation will continue.) With respect to Item 303, the court of appeals did not re-cover the ground that it had trodden in Stratte-McClure, but did helpfully decide that a “known trend or uncertainty” must be actually known to management, and that it is not enough that management “should have known” of it. 818 F.3d at 95.
Less helpfully, the court took away much of the benefit of its requirement that an Item 303-based claim must satisfy the materiality requirements of Basic by reemphasizing that a securities complaint “‘may not properly be dismissed … on the ground that the alleged misstatements or omissions are not material unless they are so obviously unimportant to a reasonable investor that reasonable minds could not differ on the question of their importance.’” Id. at 96, quoting ECA, Local 134 IBEW Joint Pension Tr. Of Chi. v. JP Morgan Chase Co., 553 F.3d 187, 197 (2d Cir. 2009) and Ganino v. Citizens Utils. Co., 228 F.3d 154, 162 (2d Cir. 2000). The gossamer protection for defendants that is provided by the Second Circuit’s materiality requirement for Item 303-based claims is further illustrated by the same court’s discussion of materiality in Litwin v. Blackstone Group, L.P., where the court noted that “even at the summary judgment stage, the ‘determination [of materiality] requires delicate assessments of the inferences a “reasonable shareholder” would draw from a given set of facts and the significance of those inferences to him, and these assessments are peculiarly ones for the trier of fact.’” 634 F.3d at 717, quoting TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 450 (1976). Essentially, the Second Circuit is saying that, to benefit from the materiality requirement, the defendant must stand trial.
The Second Circuit’s innovation in Stratte-McClure and Leidos lay in treating omissions of Item 303 disclosures as breaches of a duty to disclose under Rule 10b-5. Until Stratte-McClure and Leidos, liability for Item 303 omissions was confined to SEC enforcement actions, generally brought under Section 13(a) of the Exchange Act, and to private actions involving public offerings of securities under Sections 11 and 12 of the Securities Act. This state of the law made sense from the standpoint of statutory coverage, because Section 13(a) of the Exchange Act and Sections 11 and 12 of the Securities Act are all focused on an issuer’s or a registrant’s compliance with SEC filing requirements, which include completeness under Regulation S-K. Rule 10b-5, in contrast, does not predicate liability on documents that merely are incomplete. Instead, absent a fiduciary-like “relationship of trust and confidence between parties to a transaction,” see Chiarella v. United States, 445 U.S. 226, 230 (1980), Rule 10b-5 only requires disclosure of material information “when necessary ‘to make … statements made, in the light of the circumstances under which they were made, not misleading.’” Matrixx Initiatives v. Siracusano, 563 U.S. at 44. This does not immunize false Item 303 disclosures; under Matrixx, if a company affirmatively discusses a trend or uncertainty in its MD&A (or anywhere else in its disclosure documents), that discussion must be truthful, and the company may not knowingly or recklessly omit from that discussion any material facts that are needed to prevent that discussion from being misleading. Nor can an Item 303 omission shield a company from Rule 10b-5 liability that otherwise would exist; if a company’s SEC filings not only violate Item 303, but also, for example, materially violate GAAP (as with many of the SEC enforcement cases discussed above), a Rule 10b-5 case may be brought over the GAAP violation. However, under pre- Stratte-McClure law, an Item 303 omission is not a sword in the hands of a Rule 10b-5 plaintiff.
The Second Circuit’s holding that Item 303 creates an affirmative duty to disclose under Rule 10b-5 supplies that sword and is very difficult to square not only with the language of Rule 10b-5, but also with prior Supreme Court authority.
First, particularly if the Supreme Court were to accept the Second Circuit’s view in Stratte-McClure, which the Leidos court followed, that any omission of required disclosure constitutes a “half-truth,” it would render almost meaningless the Supreme Court’s statement in Matrixx that “[e]ven with respect to information that a reasonable investor might consider material, companies can control what they have to disclose under these provisions by controlling what they say to the market.” Id. at 45. Stratte-McClure and Leidos contain no stopping point that would prevent all of the SEC’s disclosure rules from being incorporated into Rule 10b-5, potentially swamping companies’ control over what they say with extraneous information such as inconclusive judgment calls as to the probability of a material adverse outcome to a trend or uncertainty. It is true, of course, that, since SEC rules oblige public companies to make certain kinds of disclosures, those requirements would remain in place even if Leidos is reversed. But as we demonstrate in Part III below, Rule 10b-5 liability will inevitably spur “defensive” disclosure that otherwise would not happen and that, once made, will multiply the areas in which public companies find themselves speaking.
Second, the notion that a reasonable investor would observe and rely on the absence of particular “trend or uncertainty” disclosure and conclude, based on that absence, that that trend or uncertainty did not exist, see Stratte-McClure, 776 F.3d at 102, stretches the concept of the “reasonable investor” beyond recognition. To be sure, omissions analysis “brings the reasonable person into the analysis, and asks what she would naturally understand a statement to convey beyond its literal meaning.” See Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund, __ U.S. __, 135 S.Ct. 1318, 1331-32 (2015). It is fair to assume certain background knowledge by a reasonable investor who is reading an SEC filing, such as conversancy with the English language, or the understanding that the financial statements in that filing are based upon GAAP, or even, as the Supreme Court noted in Omnicare, “the customs and practices of the relevant industry.” 135 S.Ct. 1330. It is quite another thing – and quite counterintuitive -- to assume that the reasonable investor has an SEC disclosure lawyer’s conversancy with all of the particular requirements for SEC filings and the SEC’s glosses on those requirements, and thus has the ability to notice the absence of an Item 303 disclosure.
The evidence available on the SEC’s Website regarding what a reasonable investor would know, or might assume, from reading an SEC filing does not suggest that level of discernment. The “Mandatory Disclosure Documents Telephone Survey,” a July 30, 2008 report by Abt ARBI that was commissioned by the SEC’s Office of Investor Education and Advocacy, concluded that many investors do not read disclosure documents. Seehttp://www.sec.gov/pdf/disclosuredocs.pdf at iv. Of those who said they received annual reports, over half said that they rarely, if ever, read them. ( Id. at 12.) Among the investors who read annual reports, only 9% said that they typically look for the MD&A. ( Id. at 17.) The Executive Summary of the Survey, noting investor confusion about the intended contents of SEC disclosure documents in general, observed that “[i]n light of this, it is not enough to simply clear up the language and reduce the legal jargon in the disclosure documents. It needs to be made clear to investors what key information is contained in each document.” ( Id. at iv.) As regards the MD&A, the SEC’s Website guidance for investors on “How to Read a 10-K” is less than helpful in assessing what a reasonable investor should understand; that guidance explains that the MD&A must disclose “any known trends or uncertainties that could materially affect the company’s results” [emphasis added], which is a different trigger for disclosure than those set forth in either Item 303 or the Two Step Test. ( Seehttp://www.sec.gov/fast-answers/answersreeda10khtm.html (July 1, 2011).) And even if a reasonable investor noticed the absence of a disclosure about a trend or uncertainty, that reasonable investor would be unable to conclude that the trend or uncertainty in question did not exist, as opposed to being extant but unknown to the registrant’s management, or being extant and known to management but not reasonably likely to have a material impact on the registrant’s operations.
Third, although it was helpful of the Second Circuit to hold in Leidos that “known,” in the phrase “known trend or uncertainty,” means actually known to management, the application of a scienter-based provision like Rule 10b-5 to management’s assessment of the “known trend or uncertainty” under Item 303 is not so simple. The example of possible tornado damage to a registrant’s factory may help make the point. Leidos plainly requires that, to violate Item 303 with respect to the risk or uncertainty posed by a particular tornado, management must actually have seen (or otherwise learned of) a funnel cloud on the horizon; the fact that management should have looked out the window, but did not, will not suffice.
However, seeing the funnel cloud is only the predicate to an Item 303 violation; once management has seen the funnel cloud, the SEC expects it to apply the Two Step Test, which goes beyond the language in Item 303, to assess whether the trend or uncertainty represented by the funnel cloud is reasonably likely to come to fruition (is it actually a tornado and is it heading toward the factory?) and, if management cannot determine that it is not reasonably likely to materialize, to “evaluate objectively” the consequences of the known trend or uncertainty on the assumption that it does come to fruition and then disclose it “unless management determines that a material effect on the registrant’s financial condition or results of operations is not reasonably likely to occur” (is the storm severe, and is the factory resilient?). The 1989 Release couches each of these determinations in terms of what is “reasonable,” invoking the classic “reasonable person” standard of negligence cases. But negligence was rejected as a basis for Rule 10b-5 liability more than forty years ago. See Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 n. 12 (1976) (holding that Rule 10b-5 claims require scienter, defined as “a mental state embracing intent to deceive, manipulate, or defraud”).
If there were any doubt about the mental state contemplated by the SEC’s 1989 Release, the Release itself notes that “[e]ach final determination resulting from the assessments made by management must be objectively reasonable, viewed as of the time that the determination is made.” 1989 Release at 7 [emphasis added]. Scienter, in contrast, is a mental state, which is inherently subjective; the defendant must be proved either to have known what he was doing, or at least to have acted recklessly – defined not as a heightened form of negligence, but as “an extreme departure from the standards of ordinary care, … which presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor must have been aware of it.” In re Alpharma Inc. Securities Litigation, 372 F.3d 137, 148 (3d Cir. 2004). The management determinations required by Item 303, as construed in the SEC’s 1989 Release and in Bank of Boston (the only “pure” Item 303 case that the SEC has litigated) plainly are designed to be evaluated under a negligence standard, which works well for non-scienter statutes such as Sections 11 and 12 of the Securities Act or Section 13(a) of the Exchange Act, but does not work at all for Rule 10b-5. It is possible, of course, to patch over this gap by adding a requirement that the plaintiff in a Rule 10b-5 case based on Item 303 must show Rule 10b-5 scienter and not just negligence, just as Stratte-McClure did with materiality by superimposing Basic v. Levinson on Item 303, which requires something less than materiality under the 1989 Release. Indeed, the Stratte-McClure court may have done exactly that when it ruled that the plaintiff there failed to show adequate scienter by the defendant in that case. But at some point such patches become the legal counterparts of the epicycles (circles on circles) that our ancestors added to their earth-centered model of the universe in an effort to account for the observed movements of the planets – less a rational adaptation of the model than a demonstration that the model (in this case, equating the requirements of Regulation S-K with Rule 10b-5 duties to disclose) does not make sense. And as we show in Part III below, it is also true that the assessments demanded of management by Item 303 and the 1989 Release inevitably will be opinions of management which will not even be false (let alone knowingly or recklessly false) unless a plaintiff can prove that the opinion was not genuinely held under Omnicare; the substitutes for such proof that the Court pointed to in Omnicare (statements of fact embedded in the opinion, or a reasonable investor’s inference, from the opinion itself, that it must have a basis) will not, by definition, be available in the context of an opinion that justified an omission of disclosure.
Fourth, another reason (in addition to statutory language) why the conclusion that Item 303 can support liability under Sections 11 and 12 does not lead to the same conclusion for Section 10(b) and Rule 10b-5 is that Sections 11 and 12 are express liability provisions established by Congress, whereas private claims under Section 10(b) and Rule 10b-5 are judicially-implied creations that, at most, were acknowledged by Congress when it passed the Private Securities Litigation Reform Act in 1995. The Supreme Court cautioned in Stoneridge Inv. Partners, LLC v. Sci.-Atlanta, Inc., 552 U.S. 148, 165 (2008) that “[t]hough it remains the law, the § 10(b) private right should not be extended beyond its present boundaries.” As this article makes clear, the use of Item 303 (let alone the myriad other SEC rules that would logically follow with it, as well as future rules adopted to respond to emerging issues and the increasing complexity of financial reporting) to create a new disclosure duty under Rule 10b-5 would be just such an extension.
Finally, while we recognize that “[p]olicy considerations cannot override … the text and structure of the [Exchange] Act,” Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164, 188 (1994), and that “Congress gets to make policy, not the courts,” Omnicare, __ U.S. at __, 135 S.Ct. at 1331, this is a case in which the text and structure of the law and public policy are fully consistent. As we show above and below, the pre- Stratte-McClure understanding of the law served policy objectives by limiting the damage private litigants might do to the SEC’s objectives in promulgating Item 303 in the first place, and also by limiting the distortive effect that private liability might have on registrants’ disclosure decisions not only under Item 303, but under other SEC rules adopted under Sections 13(a), 15(d), and perhaps 14(a) rather than the antifraud provisions. Both law and policy lead to the conclusion that the Second Circuit’s Item 303 ruling in Leidos should be reversed.
In this section, we discuss the impact that Supreme Court affirmance of Leidos would have on: (a) how management approaches the disclosure of known trends or uncertainties under Item 303(a); and (b) how an affirmance of Leidos can be expected to affect the disclosure required by other sub-items of Item 303 and by other items of Regulation S-K, as well as other SEC rules.
As discussed in Part I, when it adopted Item 303, the SEC wanted to replace the check-the-box, mechanistic disclosure of Guides 1 and 22 with meaningful disclosure. To accomplish this goal, the SEC adopted a flexible, general, principles-based rule to give public company managements the opportunity to tell their stories. MD&A has been a challenging task for both managements of public companies and the SEC. To provide guidance on what the SEC has in mind, it has issued over a dozen interpretive releases over the past 37 years. Despite the challenges, the SEC has never abandoned the flexible, principles-based approach that Item 303 established, presumably because the agency continues to believe that an MD&A that enables shareholders to see the business through the eyes of management results in more meaningful information to shareholders and the investing public than a more prescriptive, check-the-box standard would provide. Simply put, MD&A remains the core narrative discussion about the financial statements and what management thinks about its current performance as an indicator of what future results might be.
As we note above, it is clear under existing law that if a company affirmatively discloses a trend or uncertainty in its MD&A, that disclosure must be truthful, and the company may not knowingly or recklessly omit from that disclosure any material facts that are needed to prevent the discussion of that trend or uncertainty from being misleading. Affirmance of the Second Circuit’s view in Stratte-McClure/Leidos that Item 303(a)(3)(ii) creates a freestanding duty, actionable under Rule 10b-5, to disclose wholly-omitted information, or that the omission of any information required in a disclosure document constitutes a “half-truth” under Rule 10b-5, has the potential to result in significant litigation in which plaintiffs allege violations with 20-20 hindsight and in which disclosure documents, and in particular disclosure in MD&A, become a trap for the unwary. We believe that public companies would understand that risk and adapt to it. That adaptation would likely represent a fundamental change in how managements perceive MD&A and how they comply with Item 303(a)(3)(ii).
Under Leidos, a plaintiff need only allege that a company violated an SEC disclosure rule, such as Item 303, and acted with scienter and that the violation was material. Leidos states that Item 303 requires disclosure of “the manner in which th[at] then-known trend [ ], event[ ],or uncertaint[y] might reasonably be expected to materially impact [Leidos’] future revenues” [emphasis added]. Leidos, 818 F.3d at 96, citing Litwin v. The Blackstone Group, L.P., 634 F.3d at 719. Item 303, on the other hand, requires disclosure of a trend or uncertainty that “the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations” [emphasis added]. A might standard would trigger more disclosure than a will or would standard. Thus, under Leidos, a plaintiff could simply claim that a company omitted disclosure about a trend or uncertainty that management reasonably expected might have a material impact on the company’s future liquidity, capital resources or revenues. Since a plaintiff will only bring such a lawsuit when a company has had a significantly adverse outcome to a trend or uncertainty, the plaintiff is likely to be able to sufficiently allege the materiality of the omission to withstand a motion to dismiss the complaint. And as noted in Part II above, courts generally do not dismiss a complaint, or grant summary judgment, based on a defendant’s claim that an omission is not material, so that lack of materiality is unlikely to save a defendant from having to go to trial, or settle the case. While, presumably, a plaintiff would also have to make plausible allegations that the company acted with the requisite scienter when it violated a disclosure rule, such as Item 303, that, too, may not be very difficult when the plaintiff alleges that management knew about the trend or uncertainty at the time of filing and the company’s performance or financial condition has already been affected in a materially adverse way by the outcome of a known trend or uncertainty.
An affirmance of Leidos would not make registrants’ crystal balls into the future any clearer and the assessment of the need for disclosures about trends and uncertainties would remain very difficult. In light of those difficulties, companies would likely take a defensive approach in drafting MD&A. Rather than MD&A being approached as an opportunity for management to tell its story and to seek to enable investors to see the company through the eyes of management, management would approach MD&A as requiring a check-the-box approach and defensive disclosures given the potential risk of an expensive class action related to an omission of material information. The Rule 10b-5 risk related to trends and uncertainties would require far more rigorous procedures to effectively identify and evaluate any possible trends and uncertainties and to draft more protective discussions about any disclosed trend or uncertainty because an adverse impact is reasonably possible or disclosure is required under the Two Step Test.
In general, one can expect managements to change the way in which they exercise their judgment from seeking disclosure that enables investors to see the business through the eyes of management to disclosing information that is intended to protect the company from the risk of liability. Such a change would likely increase the costs and burdens of compliance without providing meaningful disclosure to investors. Today, the drafting of MD&A is often controlled by the accounting staff under the supervision of the controller or the chief financial officer with input from the disclosure committee and attorneys. Drafting takes into account information from various parts of the company as well as information that management has communicated to the board of directors. In a post- Leidos affirmance environment, lawyers would likely play a much more significant role than today and MD&A would look much less like management telling its story. Not only would companies need to conduct more rigorous searches for and evaluations of possible trends and uncertainties; they also would need to involve outside disclosure and litigation counsel to a much greater extent because of the concern that an omission could lead to the significantly higher risks relating to a Rule 10b-5 class action for monetary damages than the risk of an action for an injunction or a cease and desist order brought by the SEC to enforce its rules. Companies would need to draft reports under the Exchange Act in the same manner that they draft registration statements and prospectuses, with full awareness of the Rule 10b-5 risk. Companies’ disclosures about trends and uncertainties would increase. MD&As would become longer, more complex and defensive.
Longer and more complex disclosures would be even less readable and provide limited additional meaningful information to investors. The risk of material information being obscured would increase, leading to “disclosure overload.” See, e.g., Speech by then Commissioner Troy A. Paredes, Remarks at the SEC Speaks in 2013 (Feb. 22, 2013) available at https://www.sec.gov/news/speech/2013-spch022213taphtm. In his first public address, SEC Chairman Jay Clayton observed that over the past two decades “studies show the median word-count for SEC filings has more than doubled, yet readability of those documents is at an all-time low. SEC Chairman Jay Clayton, Remarks at the Economic Club of New York, 1 (July 12, 2017) (“Chairman Clayton’s Speech”) available at https://www.sec.gov/news/speech/remarks-economic-club-new-york. As support for this statement, footnote 8 of Chairman Clayton’s Speech at 7 cites Travis Dyer, Mark Lang, Lorien Stice-Lawrence, “The Evolution of 10-K Textual Disclosure Evidence from Latent Dirichlet Allocation” (October 2016) and the SEC Office of the Investor Advocate, “Report on Objectives: Fiscal Year 2017,” 5 (June 30, 2016), available at https://www.sec.gov/advocate/reportspubs/annual-reports/sec-office-investor-advocate-report-on-objectives-fy2017.pdf. Ironically, if public companies respond to an affirmance of Leidos by disclosing more information, it could defeat the SEC’s purpose in adopting Item 303 of investors seeing the business through the eyes of management. Instead of seeing the business through the eyes of management, investors would see a plethora of information disclosed to avoid potential liability. In contrast, if the Supreme Court were to reverse Leidos, public companies and their legal advisors that have begun to prepare for a Leidos affirmance by disclosing more information about trends and uncertainties would revert to the status quo ante.
If the Supreme Court affirms Leidos, the decision may also agree with Stratte-McClure (the underpinning of Leidos) that the Item 303-based duty involves the application of the Two Step Test. In that event, public companies would need to review their DC&Ps. To be sure that their DC&Ps are consistent with the Two Step Test, registrants would need to have policies and procedures in place and operating at a reasonable assurance level to identify, evaluate and disclose all trends and uncertainties that might adversely affect them in the future. DC&Ps are defined in Rule 13a-15(a) under the Exchange Act as controls and procedures “that are designed to ensure” that a company complies with the disclosure requirements applicable to reports and other documents filed under the Exchange Act. It is likely that registrants would need enhanced DC&Ps designed to ferret out all trends and uncertainties, including those that previously were omitted as not being required because management could not conclude that it was reasonably possible that they would adversely affect the company’s liquidity, capital resources or results of operations. In addition, the drafting of appropriate disclosures about known trends and uncertainties might involve new and rigorous review processes and would have to involve all of the relevant participants.
With respect to identifying trends and uncertainties, a company might start with the risks identified in the preceding year’s Annual Report on Form 10-K and all operational events and plans that might affect the company’s future profitability. Particularly after the SEC’s recent enforcement case In the Matter of Kirschner and Rodick, discussed in Part I above, a company might want to consider amending sub-certifications from employees to elicit information about trends and uncertainties that middle-level managers are seeing in the company’s operations. The list of possible trends and uncertainties may include any that management has reported to the board of directors or that management is monitoring, including as a result of the company’s enterprise risk management process. Involvement by the senior management and the board of directors in the identification of trends and uncertainties would be even more important in a post- Leidos affirmance environment than it is today because of the risk of Rule 10b-5 liability for omissions of disclosure about known trends and uncertainties. After the identification process is complete, each trend and uncertainty that has been identified would have to be evaluated.
The evaluation of possible trends and uncertainties with a view to whether disclosure should be made would require a company, including the disclosure committee, to assess each identified trend and uncertainty to determine whether the trend or uncertainty is reasonably likely to materially affect the company’s liquidity, capital resources or results of operations. Affirmance of Leidos would require companies to evaluate trends and uncertainties under the Two Step Test whenever they cannot conclude that the trend or uncertainty is reasonably likely to materially affect the company’s liquidity, capital resources or results of operations. This process would require more intense participation by lawyers because of the highly judgmental evaluation required by that test and the risk of a class action suit involving an omission to disclose a known trend or uncertainty that is brought by a plaintiff with the benefit of hindsight. Given the potential liability that companies may face in the post- Leidos environment, as described above, it is unlikely that management would be able to conclude that many of the trends or uncertainties that remain on its list for evaluation under the Two Step Test can be excluded under the first step of the Two Step Test, viz. they are not reasonably likely to occur. Therefore, the company would need to assess under the second step of the Two Step Test whether, assuming that the trend or uncertainty occurs, it is not reasonably likely to have a materially adverse effect on the company. The second step requires disclosure unless management concludes that the outcome of the trend or uncertainty is not reasonably likely to be material. In light of the potential Rule 10b-5 liability for failure to disclose a trend or uncertainty, we believe that registrants would err on the side of more disclosure about trends and uncertainties. This defensive application of the Two Step Test would result in a discussion intended to avoid liability rather than a discussion and analysis focused on providing investors “the opportunity to look at the company through the eyes of management,” as explained in the 1987 Release. 1987 Release at 13717. Whether a company would also have to consider the likelihood of a materially adverse effect of a trend or uncertainty on its results, liquidity or capital resources based on the “might” standard articulated in Leidos or the “could” standard articulated on the SEC’s Website would depend on what the Supreme Court says in any opinion that affirms Leidos.
The drafting of the disclosure about each known trend or uncertainty that must be disclosed would also involve a more rigorous and time-consuming process by management than the principles-based process of today and would require the involvement of more people. The process would be intended to craft disclosure that does not unduly alarm investors, but, at the same time, does not unduly minimize the extent of the outcome of the disclosed trend or uncertainty. The process would also need to consider any prejudice on the outcome of any related litigation or other conflict situations or any competitive harm. In addition, the drafting process would need to consider the accounting and financial statement disclosure consequences of the additional disclosures about known trends or uncertainties.
The Rule 10b-5 risk would also result in more attention to the Court’s decision in Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund, __ U.S. __, 135 S.Ct. 1318 (2015) and to the safe harbors for forward-looking statements. Even though Omnicare was decided under Section 11 of the Securities Act, the decision can protect any opinions articulated in the MD&As of periodic reports. See L. Griggs, J. Huber, C. Mixter, “Omnicare and GAAP-Based ‘Numerical Opinions,’” 47 SRLR 1293 (June 29, 2015); L. Griggs, J. Huber, C. Mixter, “The SEC’s Renewed Interest in Accounting Cases – A New Beginning or a Victim of Fait?”, 45 SRLR 1663 (Sept. 16, 2013). To obtain that protection, however, the disclosure should make clear that the outcome of both trends or uncertainties that are disclosed and those that are not disclosed are opinions. In addition, the disclosure should identify any forward-looking statements in the disclosure, such as the statements about the possible outcome of a trend or uncertainty, and describe the assumptions underlying management’s judgment on the future impact of the trend or uncertainty on the company so that the company has the benefit of the safe harbor rule for forward-looking statements. Section 21E of the Exchange Act provides protection from liability for a forward-looking statement made by a company subject to the reporting requirements of the Exchange Act provided that the forward-looking statement is identified as a forward-looking statement and is accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statement.
Finally, while a company’s goal may be to draft disclosure about known trends or uncertainties that is transparent, balanced, and as useful to investors as possible, it may be a difficult goal to achieve because the disclosure is likely also to be complex and uncertain, given the nature of trends and uncertainties. Therefore, the disclosure would likely be of somewhat limited value to an investor trying to assess the likely impact of the trend or uncertainty on the company’s future liquidity, capital resources or results of operations. As managements draft increasingly defensive disclosure to respond to affirmance of Leidos, the expanded disclosures may cause plaintiffs to claim that the companies violated the “buried facts” doctrine of Rule 10b-5. See Werner v. Werner, 267 F.3d 288, 298 (3d Cir. 2001) (describing doctrine); Kas v. Financial General Bankshares, Inc., 796 F.2d 508, 516 (D.C. Cir. 1986) (describing the doctrine as providing that “‘[f]ull and fair disclosure cannot be achieved through piecemeal release of subsidiary facts which if stated together might provide a sufficient statement of the ultimate fact,’” citing Kennedy v. Tallant, 710 F.2d 711, 720 (11th Cir. 1983), but as requiring “ some conceivable danger that the reasonable shareholder would fail to realize the correlation and overall import of the various facts interspersed throughout the proxy” [emphasis in original] ). So a balancing of potential competing Rule 10b-5 claims may be needed. Moreover, the disclosure of more known trends and uncertainties can result in more questions from analysts on earnings calls as well as competitive issues with other companies that have businesses in the same or similar segments, whether they are publicly or privately held.
In short, affirmance would increase the time that public companies spend on preparing disclosures about trends and uncertainties in MD&A, increase the related costs, and increase the amount of information about such trends and uncertainties, potentially overwhelming investors with so much disclosure that they are unable to fully assess which trends or uncertainties are really important to their investment decision. These negative results would outweigh any benefits of greater attention to disclosures about trends and uncertainties resulting from an affirmance by the Court of Leidos. The unanticipated effects of such a decision may include fewer companies making initial public offerings and more companies determining to go private to avoid the risk of management being second guessed in litigation that can expose the company to enterprise-threatening litigation. SEC Chairman Clayton has noted that “[i]ncremental regulatory changes may not seem individually significant, but, in the aggregate, they can dramatically affect the markets,” and “ the roughly 50% decline in the total number of U.S.-listed public companies over the last two decades forces us to question whether our analysis should be cumulative as well as incremental.” Chairman Clayton’s Speech at 2. When Item 303 was adopted in 1980, there were approximately 12,500 registrants reporting to the SEC under the Exchange Act. Magnifying the effect of MD&A by engrafting it onto Rule 10b-5 cannot help but accelerate this trend.
Neither Stratte-McClure nor Leidos contains any limiting principle that would prevent all of the sub-items of Item 303 and all of the SEC’s specific disclosure rules adopted under other sections of the securities laws from supplying “duties to disclose” under Rule 10b-5. If Item 303(a)(3)(ii) creates a duty to disclose that is enforceable by private plaintiffs under Rule 10b-5, that duty would impact the entire MD&A, and not just the disclosures about trends and uncertainties affecting net sales or revenues or income from continuing operations. Such a duty could also apply to all the other items in Regulation S-K as well as to other rules and regulations adopted pursuant to the SEC’s authority under Sections 13(a) and 15(d), and perhaps even Section 14(a).
To begin with Item 303, Item 303(a)(1) and Item 303(a)(2)(ii) require disclosure about known trends or uncertainties that “that will result in or that are reasonably likely to result in the registrant’s liquidity increasing or decreasing in any material way” and “known material trends, favorable or unfavorable, in the registrant’s capital resources,” respectively. Other sections of Item 303 require disclosure of additional information necessary to an understanding of the financial statements, including significant events, transactions or economic changes that affected the reported results. Item 303(a) requires disclosure of “such other information that the registrant believes to be necessary to an understanding of its financial condition, changes in financial condition and results of operations.” Similarly, the second sentence of Item 303(a)(3)(i) requires a description of “any other significant components of revenues or expenses that, in the registrant’s judgment, should be described in order to understand the registrant’s result of operations.” In contrast to broad and general requirements, the first sentence of Item 303(a)(3)(i) requires registrants to describe “any unusual or infrequent events or transactions or any significant economic changes that materially affected the amount of reported income from continuing operations and, in each case, indicate the extent to which income was so affected.”
With the benefit of hindsight, a plaintiff may be able to identify other information that a registrant failed to disclose in accordance with these principles-based disclosure requirements even though the registrant was aware of the possible importance of the information but reached a different judgment at the time the periodic report was filed. The risk of class action liability under Rule 10b-5 for omissions from an MD&A in a Form 10-K or Form 10-Q will mean that companies will have to approach the drafting of MD&A in a more disciplined and formal process so that management judgments about whether to omit any information take into account the Rule 10b-5 risk related to the omission. Whereas today, a company can choose to remain silent and decide not to conduct a public offering that would expose it to the risk of significant liability as a result of a material omission from the registration statement or prospectus for the offering (or any report or portions of a proxy statement filed under the Exchange Act that are incorporated by reference into the registration statement and prospectus) at a time when it is unable to make difficult judgments about required disclosures, a Supreme Court decision that Item 303 creates a duty to disclose that is actionable under Rule 10b-5 would require a company to consider the class action risks of omissions each time it files its periodic and current reports and proxy statements under the Exchange Act. Any difficult judgments about the extent of required disclosures would likely lead simply to more disclosure, including possibly disclosure that is not material, is confusing or obfuscates material information, rather than an omission of disclosure that would expose the company to the risk of Rule 10b-5 liability.
Besides Item 303, other items in Regulation S-K use the terms trend or uncertainty. For example, Instruction 2 to Item 301, Selected Financial Data, requires the five year financial data disclosure to include “[D]iscussion of, or reference to, any material uncertainties … where such matters might cause the data reflected herein not to be indicative of the registrant’s future financial condition or results of operations.” When the selected financial data includes interim periods, Instruction 4 to Instructions to Item 301 requires the interim periods to be updated “to reflect a material change in the trends indicated… .”
As with the other sub-items of Item 303 that do not refer to trends or uncertainties, a number of other items and sub-items of Regulation S-K could be the basis for a complaint by a private plaintiff in a post- Leidos environment. For example, Item 103, Legal Proceedings, requires disclosure of “any material legal proceedings, other than ordinary routine litigation incidental to the business…” A plaintiff may allege, with the benefit of hindsight, that a legal proceeding should have been disclosed even though management had concluded that it was “ordinary routine litigation incidental to the business.”
Another example is Item 402, Executive Compensation, which has been the subject of much review and controversy over the years. Compensation Committee decisions concerning the pricing of stock options, known as options backdating, were the subject of much controversy and many restatements of financial statements in the mid-2000s. Query whether certain types of current compensation arrangements could meet the same fate as options backdating and result in private plaintiffs bringing Rule 10b-5 actions in the future.
In addition to current items in Regulation S-K, the SEC could adopt new or amend existing disclosure items that could also result in Rule 10b-5 litigation in a post- Leidos environment. If the Court affirms Leidos, public companies would continue to face the Division’s review staff, which would be expecting MD&As to disclose how management sees the business. As discussed above, the additional disclosure in MD&As may blur management’s vision because disclosure about known trends and uncertainties would reasonably be expected to multiply, thus obfuscating what management sees. This would result in MD&As being even less readable and information overload increasing. Public companies would also face increased insurance premiums as well as other increases in costs of compliance and the need to fit more processes and people into already crowded preparation schedules for filing periodic reports on a timely basis. In addition to these known uncertainties as a result of the court affirming Leidos, public companies would be expected to face a new and very uncertain challenge that is different than what they have faced in the past. Affirming Leidos could mean that companies would be required to approach the drafting of periodic and current reports filed under the Exchange Act in the same way that they approach the drafting of registration statements and prospectuses. They would have to consider the risk of costly class action litigation resulting from an omission that, viewed in hindsight, was a material omission of information required by an SEC disclosure rule or item.
A decision by the Supreme Court affirming Leidos would defeat the SEC’s purpose in adopting MD&A as expressed in 37 years of administrative history, would represent an unwarranted expansion of the scope of the Rule 10b-5 private action, and would increase compliance costs while replacing meaningful disclosure aimed at letting managements “tell their story” with immaterial, defensive disclosure that would help neither shareholders nor the investing public.
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